It’s All About Timing: Will Karns Impact the IRS Battles over Advance Receipts?
Nicholas A. Mirkay III
Creighton University - School of Law
November 22, 2010
Delaware Law Review, Vol. 12, No. 1, 2010
Widener Law School Legal Studies Research Paper No. 10-45
The accounting for advance receipts or payments continues to vex those who administer, and advise on, federal income tax law. Under current income tax law, a taxpayer or tax advisor must generally make an initial threshold determination when addressing the tax treatment of an advance receipt: (i) is the amount received a loan or deposit, neither of which is generally required to be included in income; or (ii) is the receipt not a loan or deposit and, thus, includable in income as an “accession to wealth,” such as salary or wage income. The U.S. Supreme Court has addressed the proper federal income tax treatment of various forms of advance receipts in numerous decisions over the last four decades, the most recent of which occurred in its 1990 decision in Commissioner v. Indianapolis Power & Light Co. In Indianapolis Power, the Court held that a public utility’s receipt of a deposit was not includable in income at the time of receipt, finding there was a significant difference between a deposit and an otherwise “advance payment” for federal income tax purposes. Although practitioners and legal scholars hoped Indianapolis Power would provide some final clarity, it has nevertheless been criticized as lacking the necessary economic foundation and analysis on which income taxation should rely.
Several federal circuit courts of appeal have applied Indianapolis Power subsequently with varying degrees of consistency. In Westpac Pacific Food v. Commissioner, the Ninth Circuit determined that advance trade discounts received by the taxpayer in consideration for committing to future volume purchases were akin to security deposits or loans and, thus, not includable in gross income in the year of receipt. On virtually identical facts to those in Westpac, the Third Circuit, in Karns Prime & Fancy Food, Ltd. v. Commissioner, openly disagreed with Westpac and the Ninth Circuit’s application of Indianapolis Power, concluding that funds provided to the taxpayer by its food supplier in exchange for a promissory note and a supply agreement constituted taxable income to the taxpayer in the year of receipt. This article more closely analyzes Karns, and its impact, if any, on future applications of law in this area.
Like other commentators, the article questions the validity of the loan versus other advance payment distinction. Accordingly, the article criticizes Indianapolis Power for perpetuating this distinction and for potentially misapplying its own-stated distinction by inaccurately viewing the deposits received by the taxpayer as loans rather than advance payments for future utility services. Because the Third Circuit in Karns limited its decision and discussion as to whether the cash advance received by the taxpayer constituted a loan, it missed an opportunity to further clarify the disparate tax treatment of other advance payments. Nevertheless, the article ultimately concludes that the Third Circuit correctly applied precedent and ultimately got it right in Karns. By utilizing Indianapolis Power and distinguishing Westpac, the clear import of Karns is that the more two parties to a transaction treat an advance payment (or an advance trade discount) as a loan from its inception, the more likely the recipient will prevail against the IRS in excluding that advance from income upon receipt.
This article originally appeared in Vol. 12 No. 1 of the Delaware Law Review, published by the Delaware State Bar Association. Copyright © Delaware State Bar Association 2010. All rights reserved. Reprinted with permission.
Number of Pages in PDF File: 25
Keywords: taxation, advance receipts, tax, advance payments, income tax
JEL Classification: K34
Date posted: November 25, 2010